But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.
Different real estate indices follow their own distinct methodologies
There are several widely used real estate indices that professionals use to monitor the markets. The most widely known and used index is the Case-Shiller index of real estate values. The second is the Federal Housing Finance Agency (FHFA) index of real estate values. Radar Logic’s RPX index is another, along with CoreLogic. Each of these indices approaches the real estate market in a slightly different way.
The difficulties of creating a home price index
Coming up with increases in real estate is truly a difficult problem. For most financial assets, there are several (if not thousands) of transactions daily in the asset. For a stock, it’s simply a matter of looking at yesterday’s close and comparing it to today’s price. But what about a home? What was the price of your home worth yesterday, and what is it worth today? How do you go about calculating price changes?
The methodology most indices use is the repeat sales methodology. These indices that use this approach look at all the real estate transactions and find out the prices these transactions sold at previous to these sales. From there, the indices sort of bootstrap an index together. Problems with this methodology include changes to the property—anything from the addition of a swimming pool to an owner who lets the property fall into disrepair.
Other indicies use all data available (offered prices, as well as sales data) to create an index. This offers the benefit of being more inclusive. However, often an offered price is set too high and the property doesn’t trade.
Finally, other indices use mortgage data to intuit house prices. Of course, this approach depends on properties’ appraised value, which may or may not be correct.
The Case-Shiller index
Case-Schiller is the most widely followed index, and it uses the repeat sales methodology. It looks only at detached houses and ignores new construction. New construction is unusable because there is no previous sale with which to compare it. Case-Shiller also only focuses on arm’s-length transactions, which means it excludes transactions between family members. It also excludes major renovations and includes foreclosures. Case-Shiller excludes outsized changes because they indicate data errors.
The Federal Housing Finance Agency Index
The Federal Housing Finance Agency (FHFA) Index uses a repeat-sales methodology but focuses only on mortgages securitized by Fannie Mae or Freddie Mac. The advantage of the index is that it goes back a long way and provides excellent geographic granularity (that is, a high level of detail). Its biggest disadvantage is that it excludes a lot of the market—ignoring cash sales as well as anything that falls outside the Fannie Mae or Freddie Mac lending limits. That said, the FHFA index does represent the “median” part of the market very well.
The Radar Logic index has the advantage of being attached to futures contracts. It’s much more of a holistic index in that it looks at offered prices as well as transactions. It uses a method called “the triple power law,” which is an attempt to describe the distribution of home prices. The Radar Logic index updates prices daily.
When to use different indices
If you want to take a deep dive into local data, use FHFA. The Case-Shiller index is the most famous, and you could consider it the “Dow Jones Industrial Average” of real estate indices. Radar Logic is complicated to understand, but it has the benefit of including futures contracts that you can use to forecast price appreciation.
Implications for mortgage REITs
Real estate prices are big drivers of non-agency REITs such as CYS Investments (CYS), Newcastle (NCT), PennyMac (PMT), Redwood Trust (RWT), and Walter Investment Management (WAC). When prices rise, delinquencies drop, which is important because non-agency REITs face credit risk. Even for agency REITs, which invest in government mortgages, rising real estate prices can drive prepayments, which negatively affects their returns. Rising real estate prices also help reduce stress on the financial system, which makes securitization easier and lowers the cost of borrowing. Finally, those REITs with large legacy portfolios of securities from the bubble years can stop taking mark-to-market write-downs and may revalue their securities upwards. Since REITs must pay out most of their earnings as dividends, higher earnings mean higher cash flows to the investor.
© 2013 Market Realist, Inc.